Pay me later, please: looking for ways to boost your post-association income?

A 457(b) deferred compensation plan may be just the ticket for a more comfortable retirement.

THE ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT of 2001 may have done you a big favor. The new law enhances opportunities this year for your participation in a 457(b) plan, which is a deferred compensation arrangement that may be offered by tax-exempt organizations to certain highly compensated executives.

Until passage of this act, associations had little incentive to offer 457(b) plans because very few executives benefited by participating. That's now changed.

Two types of plans

Internal Revenue Code Section 457, which governs most of the nonqualified deferred compensation arrangements of tax-exempt organizations, describes two categories of plans:

* Section 457(b) eligible deferred compensation plans must meet the specific requirements found in the tax code and regulations.

* Section 457(f) ineligible deferred compensation plans avoid most of the rigid design rules imposed on plans eligible under Section 457(b), but all amounts deferred under the arrangement must be subject to a substantial risk of forfeiture. Your deferred compensation (and related investment earnings) must be conditioned upon the future performance of considerable services for your organization. When your benefits are no longer subject to a substantial risk of forfeiture, they become fully and immediately taxable to you.

Either type of 457 plan is required to be unfunded. This means that throughout the entire deferral period, all of your deferred compensation and related investment income remain your employer's property and are subject to the claims of your organization's general creditors.

Requirements for eligible plans

If a plan is eligible under Section 457, you are not taxed on the deferred amounts and related investment income until they are distributed or made available to you or your beneficiary, usually following retirement or termination of your employment. Some of the requirements of eligible plans are as follows:

* Maximum annual deferral. In general, your annual plan deferrals may not exceed the lesser of 1) the applicable dollar amount, which is $11,000 in $2002, or 2)100 percent of your eligible compensation.

* Distributions. Eligible plans, which generally cannot make in-service distributions, must make minimum distributions to you after you have retired and reached age 70/2.

Act offers relief

Thanks to the 2001 tax act, the dollar limit on contributions to 457(b) plans increased from $8,500 in 2001 to $11,000 in 2002. The maximum dollar amount will increase by $1,000 per year until it reaches $15,000 in 2006, after which it will adjust for inflation. The law also increased the percentage limit on contributions from 33/3 percent to 100 percent of eligible compensation. In addition, the law repealed a restrictive coordination requirement for deferral amounts.

Under prior law, if you participated in both a 457(b) plan and another deferred compensation plan (perhaps a 401(k) or 403(b) plan), you had to combine each year's deferrals and limit the total amount to the 457(b) maximum. For example, the 2001 deferral ceilings for 401(k) and 457(b) plans were $10,000 and $8,500, respectively. If you were covered by both types of plans, however, you were limited to a total deferral of $8,500, split between the two arrangements.

Rather than supplementing your retirement benefits, a 457(b) plan turned out to be detrimental to your 401(k) or 403(b) plan. Now that the coordination requirement has been eliminated, you can contribute to a 457(b) plan in addition to your elective deferrals to another retirement plan.

What are the advantages?

A 457(b) offers you certain advantages.

No requirement for substantial risk of forfeiture. The other type of nonqualified deferred compensation arrangement for tax-exempt organizations, the 457(f) ineligible plan, conditions your right to receive deferred compensation on your future performance of substantial services for your organization. This requirement can be hazardous, If the substantial risk of forfeiture is insufficient or it expires, all undistributed amounts become immediately taxable to you. As long as your plan is eligible under 457(b), you know your benefits will be tax deferred until they are distributed or made available to you.

Additional deferred compensation. A 457(b) plan allows you to double what you can set aside on a pre-tax basis. In 2002, you can contribute up to $11,000 to a 457(b) plan in addition to your employer plan contributions and 40 1(k) or 403(b) elective deferrals.

Catch-up provision. An eligible 457 plan may allow you to defer extra amounts during the last three years before reaching the plan's normal retirement age. This special catch-up opportunity is unique to 457(b) plans. You can use the catch-up election only if you did not defer the maximum amounts permitted during previous years. For years beginning after 2001, the additional contribution is limited to the lesser of 1) the maximum amount of the regular plan deferral, which is $11,000 in 2002, or 2) the total of unused, maximum deferrals for prior years.

For example, if you are within three years of the plan's normal retirement age, you can defer up to $22,000 ($11,000 ordinary plus $11,000 catch-up) under a 457(b) plan in 2002.

Non-employee participation. Section 457 covers consultants and independent contractors. While other types of retirement plans limit participation to the sponsor's actual employees, a 457(b) plan allows your organization to extend coverage to people who are not employees.

No nondiscrimination rules. Unlike qualified plans and other conventional retirement arrangements, 457 plans are not subject to nondiscrimination rules and testing. A 457(b) plan is an agreement with one or more individuals and can discriminate with respect to benefits.

Participant-directed investments. Although all 457(b) plan assets are owned solely by your employer, you, as the participant, can direct the assets into various investment options. The amount in your 457(b) plan will not be considered to have been made available to you simply because you can select investments, even if the plan has already started making payments to you.

Social Security taxation. Section 457(b) contributions are subject to FICA taxation at the time of deferral, and FICA taxes are generally not withheld from distributions. Because a highly paid employee's earnings are likely to exceed the Social Security wage base for the year in which services are performed, deferred amounts usually escape taxation of the non-Medicare portion of the FICA tax.

No penalty for early distribution. Section 457(b) plans are not subject to a 10 percent penalty on distributions made prior to age 59 1/2, unlike qualified plans, 403(b) plans, and IRAs.

IRA participation. A 457(b) plan is not a retirement plan for IRA purposes. You can defer up to $11,000 and, assuming you otherwise qualify, make a fully deductible IRA contribution for the same tax year.

SIMPLE plan participation. In general, a SIMPLE 401(k) or SIMPLE IRA must be the only retirement plan sponsored by an employer. Because a 457(b) plan is not considered a retirement plan, your association can maintain a 457(b) arrangement while sponsoring a SIMPLE plan.

Examine the disadvantages, too

What are the disadvantages of a 457(b) plan? Several come to mind:

You have no rights in plan assets. Because a 457(b) plan must be unfunded, you cannot have any secured interest in your deferred compensation. Plan assets may not be restricted for payment of benefits, nor can they be segregated to place them beyond the reach of your organization's general creditors. This means your benefit may be jeopardized if the association's solvency or future is uncertain.

In an attempt to safeguard benefits, some nonprofit executives have created 457(b) plans in tandem with Rabbi Trusts. However, by taking this step or various other preventive measures, you cannot assure that you will receive payments if your organization becomes insolvent, it misuses plan funds, or plan investments fail.

Participation is limited to a select group of highly paid individuals. Tax-exempt entities must limit 457(b) participation to a select group of management or highly compensated individuals. (The law does not provide an objective test for eligibility based on salary or other measures. Rather, eligibility varies depending on the facts and circumstances within each association.) This requirement to limit participation results from a conflict between the Employee Retirement Income Security Act of 1974 (ERISA) and Internal Revenue Code Section 457.

ERISA generally requires that any plan providing retirement benefits to employees must be funded by a trust or annuity contract, yet a 457(b) plan must be an unfunded arrangement. A 457(b) plan will violate ERISA, therefore, unless the following exception applies: If a tax-exempt employer limits 457(b) participation to a "top hat" group (i.e., a select group of management or highly compensated employees), the plan is exempt from many of the burdensome ERISA requirements.

Lack of protection under federal law. The "top hat" exemption simplifies the operation of a 457(b) plan but also leaves you isolated from ERISA's protective stipulations. Employers are generally free to design the plans to suit their particular needs and are hound by nothing more than a contractual responsibility to pay deferred compensation benefits to you or your beneficiaries.

Lack of rollover opportunities. The assets from a tax-exempt entity's 457(b) plan cannot be rolled over to an IRA, a qualified plan, or a 403(b) plan. A 457(b) balance can be rolled over only to another 457(b) plan; in effect, general assets from one association are moved into the general assets of another eligible employer.

Estate taxation. Although you do not own any amounts deferred under a 457(b) plan, account balances are included in your gross estate for federal estate tax purposes upon your death. The assets are included at their full value, despite the built-in income tax liability they carry. Distributions from the plan will also constitute "income in respect of a decedent" subject to federal income tax when paid. An income tax deduction for the estate tax attributable to the account may apply, however, to reduce the federal income tax.

Restrictions on in-service distributions. Deferred amounts cannot be distributed to you until you reach age 70/2, sever employment, retire, or face an unforeseeable emergency. Because in-service distributions are generally prohibited, you, as an active participant, have extremely limited access to the amounts you have deferred.

Loans not permitted. Proposed regulations issued in May 2002 disallow participant loans from the 457(b) plan of a tax-exempt organization. A participant loan is treated as a taxable distribution and likely to violate the prohibition on in-service withdrawals.

An option worth exploring

The Economic Growth and Tax Relief Reconciliation Act of 2001 improved the opportunities for your association to offer 457(b) eligible deferred compensation arrangements. If your organization is in sound financial health and wants to provide extra benefits to a small group of executives, a 457(b) plan is now a viable option.

RELATED ARTICLE: WHY WAIT?

Deferred compensation is a payment made in one tax year for services performed in an earlier period. A non qualified deferred compensation arrangement, often a major component of executive compensation packages, delays the taxation of compensation for services rendered but does not meet the strict rules imposed on more conventional, qualified retirement plans.

"Why wait?" you may wonder. A well-designed nonqualified agreement can provide you with significant financial planning opportunities:

* The compensation becomes taxable to you or your beneficiary when your association makes the payment or makes the deferred amount available to you, not when the income is earned. Your taxation is delayed until a future year.

* If the deferred amount earns investment income, the income is taxable to you or your beneficiary when it is distributed, not when it is earned. Your deferred compensation grows on a tax-deferred basis.

* The arrangement can supplement your retirement benefits from a conventional retirement plan, which may be severely limited by various nondiscrimination rules and by the annual compensation limit imposed in Internal Revenue Code Section 401 (a)(17).

IS THE PLAYING FIELD LEVEL?

The Internal Revenue Service mandates rules and regulations that your association must follow in setting up a deferred compensation program. Yet for-profit employers face few restrictions. Why the different treatment?

When a for-profit employer creates a nonqualified plan, simple economics keep its actions in check--the company cannot take its qualified tax deductions until the deferred compensation is actually paid. The company must also pay taxes on the deferred amounts invested on behalf of the employee, when the income is earned.

So while they may have an incentive to reward and retain key employees by offering a deferred compensation program, for-profit companies also have an incentive to keep their tax burdens low. This inherent conflict inhibits the amount of compensation that a taxable employer will allow an employee to set aside on a tax-deferred basis.

Because most nonprofit organizations do not face this built-in conflict, the IRS imposes a structure on associations that specifies how compensation can be held and allowed to accumulate on a tax-deferred basis.

Lorri Friedman, a certified public accountant and accredited pension administrator, is a senior tax manager with Bond Beebe in Bethesda, Maryland. E-mail: [e-mail]. Thomas J. St. Ville, an attorney, is a principal with Miles & Stockbridge, Baltimore, Maryland. E-mail: [e-mail].